The Canada Revenue Agency had an important win this week in its efforts to access information outside of Canada. On March 20, 2013, the Federal Court issued its decision in Soft-Moc Inc.v. M.N.R. 2013 FC 291, dismissing Soft-Moc’s judicial review application to have the CRA’s decision to issue a Foreign-Based Information Requirement set aside or varied.

The CRA has broad powers to access information related to the determination of a taxpayer’s tax obligations. Under subsection 231.6 of the Income Tax Act, these powers include the issuance of a Foreign-Based Information Requirement to obtain information or documents located outside of Canada.

In Soft-Moc, the CRA was conducting a transfer pricing audit and sought information from corporations in the Bahamas who provided services to Soft-Moc. These corporations and their individual Bahamian resident shareholder owned 90% of the common shares of Soft-Moc. The CRA issued a Foreign-Based Information Requirement to Soft-Moc under subsection 231.6(2) of the Income Tax Act.

The Requirement requested substantial amounts of information related to the Bahamas Corporations including extensive details of the services provided, customers, financial statements, costs and profits and employee data. Soft-Moc applied for judicial review of the decision to issue the requirement.

Primarily, Soft-Moc argued that the information requested went well beyond that necessary to enable the CRA to complete the transfer pricing audit and that the decision to issue the requirement was, therefore, unreasonable. Soft-Moc argued that a portion of the information requested was irrelevant and that some portions were confidential or proprietary.

The Court was not sympathetic to Soft-Moc’s arguments, noting the wide-ranging statutory powers of the CRA to collect information and the low threshold to be met in determining whether the requested information is relevant and reasonable.

This is the eleventh year in which the CRA has issued such a report, which is generally intended to enhance taxpayer awareness of the APA program and to describe (i) current operational status, (ii) relevant changes, and (iii) issues that may affect the program in future years.

The general purpose of an APA is to create certainty between the taxing authorities of Canada and a foreign country concerning the transfer pricing of cross-border intercompany transactions. In the absence of an APA governing such transactions, taxpayers may be exposed to higher audit risk relating to their intercompany transfer pricing methodologies, which may ultimately result in costly and time-consuming negotiations with the multiple tax authorities as well as potential litigation. Accordingly, the CRA encourages taxpayers to avail themselves of the APA program to mitigate the transfer pricing risk in the appropriate circumstances, particularly where the taxpayer engages in intercompany transactions of a recurring nature (i.e., frequent sale of goods between affiliates or the ongoing provision of intercompany services).

The APA program has proven popular with taxpayers over the years and the number of applicants continues to grow – the 2011-2012 fiscal year had the highest number of applicants to the program (34) since the 2007-2008 fiscal year. The inventory of unresolved cases also continues to grow (the inventory increased from 96 at the end of the 2010-2011 fiscal year to 102 at the end of the 2011-2012 fiscal year). In the 2011-2012 fiscal year, 17 new cases were admitted to the APA program whereas only 10 cases were completed (and one was withdrawn). The large discrepancy between the number of applicants and the number of cases formally admitted to the program in the year is partially a reflection of the changes introduced by the CRA beginning in the 2010-2011 fiscal year requiring that taxpayers invest significantly more time and resources during the initial application/due diligence phase of the APA process and to provide a greater amount of financial and business information prior to acceptance into the program. This results in a longer and more extensive “screening” process but is intended to eliminate inappropriate cases before they are accepted into the program inventory.

Other highlights of the Report include:

The average amount of time required to conclude a bilateral APA from acceptance into the program until completion was 44 months, which appears generally consistent with prior years;

The majority of APA’s relate to the cross-border transfer of tangible property. Approximately 47% of APA cases in process relate to tangible personal property whereas cases involving tangible personal property and intra-group services represent approximately 31% and 22% of cases in process;

The transactional net margin method (“TNMM”) continues to be the most frequently used transfer pricing methodology in APA cases; and

APAs involving the United States represent approximately 71% of all APA cases that are in process (which is slightly lower than the percentage of completed APA cases that involve the United States).

By way of background, Glaxo Canada purchased ranitidine, the active pharmaceutical ingredient in Zantac, a branded ulcer medication, from a non-arm’s-length non-resident. In 1990-1993, Glaxo Canada paid approximately $1,500 per kg of ranitidine, while generic purchasers of ranitidine were paying approximately $300 per kg. The Minister of National Revenue reassessed Glaxo Canada under former section 69 of the Income Tax Act on the basis that the taxpayer had overpaid for the ranitidine in light of the fact that generic manufacturers were paying considerably less for the same ingredient.

The issue before the Tax Court was whether the amount paid by the taxpayer to the non-arm’s-length party was “reasonable in the circumstances.” The Tax Court held that (a) the “comparable uncontrolled price” (or CUP) method was the most accurate way to determine the arm’s-length price for ranitidine and (b) the appropriate comparable transactions were the purchases of ranitidine by the generic manufacturers. Subject to a relatively minor adjustment, the Tax Court dismissed the taxpayer’s appeal.

The Federal Court of Appeal allowed the taxpayer’s appeal. The Court of Appeal held that the lower court had erred in its application of the “reasonable in the circumstances” test, and that it should have inquired into the circumstances that an arm’s-length purchaser in the taxpayer’s position would have considered relevant in deciding what reasonable price to pay for ranitidine. The Court of Appeal set aside the lower court judgment and sent the matter back to the Tax Court to be reconsidered.

The Crown appealed and Glaxo Canada cross-appealed the portion of the order sending the matter back to the Tax Court. The appeal was heard by a seven-member panel of the Court (Chief Justice McLachlin, Justice Dechamps, Justice Abella, Justice Rothstein, Justice Cromwell, Justice Moldaver and Justice Karakatsanis).

The Crown argued that the analysis under subsection 69(2) required a “stripping away” of the surrounding circumstances of the transaction in question and, in particular, the license agreement pursuant to which Glaxo Canada was entitled to market and sell the drug ranitidine under the brand name Zantac. Having done that, the only relevant comparator was the price of ranitidine on the “open market”, namely, the price paid for ranitidine by generic drug manufacturers.

The Court asked a number of questions about whether subsection 69(2) (with its reference to “in the circumstances”) makes the ultimate use of the ranitidine relevant to the analysis. Several judges asked whether it made a difference that the ranitidine purchased by Glaxo Canada was to be marketed and sold as Zantac, a branded product that would yield a higher retail price than the equivalent generic product. Justices Abella and Rothstein were particular active during this discussion.

In stark contrast to the Crown’s position, Glaxo Canada contended that the only question to be answered under subsection 69(2) was whether two arm’s-length parties, sitting across a boardroom table, would arrive at the same deal that was concluded by Glaxo Canada and its non-resident parent company. Justice Abella wondered if, even in those circumstances, an arm’s-length party would pay $1,500 for a kilogram of ranitidine.

Chief Justice McLachlin asked about bundling and its relationship to transfer pricing – if the $1,500/kg price included an amount paid for something other than ranitidine why was it not identified by Glaxo Canada as such and why was withholding tax not remitted thereon under section 212 of the Act? Counsel for Glaxo Canada responded by making two points: First, if a portion of the price paid by Glaxo Canada for ranitidine were more properly characterized as royalties, for example, such amounts would be expenses to Glaxo Canada and thus there was no mischief from a transfer pricing perspective in bundling them into the cost of the goods. Second, it is not the policy or practice of the CRA to require taxpayers to unbundle intellectual property or other intangibles from tangible property as, presumably, the practical burden imposed by such a requirement would be difficult to overstate. It was unclear whether the tension between the issues of bundling and arm’s-length pricing was resolved at the hearing.

In a nutshell, the choice before the Court is this: Is the fact that the ranitidine purchased by Glaxo Canada was destined to become Zantac relevant to the analysis under subsection 69(2)? Glaxo contends that it is, while the Crown contends that it is not.

On the cross-appeal, Glaxo Canada argued that it had met the case against it on the pleadings and the matter should, therefore, have concluded at the Federal Court of Appeal and should not have been sent back to the Tax Court. There were a number of questions from the bench on that point.

On December 19, 2011, the Tax Court dismissed a motion by General Electric Canada Company and GE Capital Canada Funding Company (the “Appellants”) in their current appeals (2010-3493(IT)G and 2010-3494(IT)G). The Appellants sought to strike several paragraphs from the Replies filed by the Crown on the basis that the Crown was relitigating a previously-decided matter. Justice Diane Campbell dismissed the motion but gave leave to the Crown to make a small amendment to one of the Replies.

General Electric Canada Company (“GECC”) is the successor by amalgamation to General Electric Capital Canada Inc. (“GECCI”), and GECC had inherited commercial debts owed by GECCI. GECC was reassessed and denied the deduction of fees paid to its parent corporation (“GECUS”) for guaranteeing the inherited debts. However, GECCI had previously litigated the deductibility of those fees and won (see General Electric Capital Canada Inc. v. The Queen, 2009 TCC 563, aff’d 2010 FCA 344). The current appeal involves similar issues, but with different taxpayers (GECC instead of GECCI) and tax years. In their application, the Appellants argued that the Crown was trying to relitigate issues that had been decided in the previous appeal.

The Court first dealt with the Appellant’s contention that res judicata precluded the Crown from having the issues reheard in another trial. Res judicata may take one of two forms: “cause of action” estoppel or “issue” estoppel. For either to apply, the parties in the current matter must have been privy to the previous concluded litigation. The Appellants said GECC had been privy to the decision since both it and GECCI were controlled by a common mind. The Court dismissed that argument since the appeals involve different tax years from those in the previous concluded litigation and, therefore, reflect different causes of action.

The Appellants also argued that it was an abuse of the Court’s process to relitigate the purpose and deductibility of the fees since the debt and the fee agreements were substantially the same as those in the previous concluded litigation. They asked the Court to strike out references to those agreements from the Replies. The Crown’s counter-argument was that the nature of the agreements was a live issue since it was not established that the fee agreements between GECUS and GECC were the same as those with GECCI. The Court agreed and refused to strike the sections of the Replies referring to the agreements.

The Appellants also sought to strike parts of the Replies where the Crown denied facts which the Appellants said had been proven in the previous concluded litigation. Again, the Court noted that the issues in the present appeals were different than those at issue in the previous concluded litigation, and that the Appellants did not show that the facts at issue (which were part of a joint statement of facts in the prior case) had actually been considered by the Court in the prior decision. Since the facts had not been proven they were best left to be determined later at trial.

Further, the Appellants contested two theories reflected in the Replies that they characterized as a fishing expedition. The Appellants stated these theories were not used as a basis for the original reassessment and, therefore, violated the restrictions on alternative arguments under subsection 152(9) of the Act. The Court dismissed this argument, saying that the theories were simply alternative approaches to showing that the guarantee fees paid by GECC were not deductible. The Court held they were alternative pleadings and refused to strike them out. Further, the Appellants also argued that two separate basis for the reassessments (one based on paragraphs 247(2)(a) and (c); the other, on paragraphs 247(2)(b) and (d)) should be pleaded as alternative grounds, since the two parts of that section were inconsistent with one another. This was dismissed on the basis that the two parts were complementary and were drafted in a way so that if both were satisfied, one would take precedence over the other.

Finally, the Appellants argued that they had been deprived of procedural fairness as the CRA had not consulted its own Transfer Pricing and Review Committee with respect to the reassessments, and the Appellants had been unable to make submissions to that committee. The Court held that there was no requirement that the committee consider the matter first and, even if there was, the Tax Court does not rule on administrative matters.

In the end, the Appellants succeeded on one minor point: the Crown will amend one paragraph in one Reply to clarify the distinction between legally binding guarantees and implied guarantees or support. The Crown was awarded costs.

A transfer pricing trial commenced on October 17, 2011, in the Tax Court of Canada in Toronto. Mr. Justice Patrick Boyle will decide whether paragraph 247(2)(a) of the Income Tax Act (the “Act”) applies to the transaction at issue (the factoring of accounts receivable) to reduce the deduction of an amount paid by a Canadian corporation to a non-resident affiliate which assumed the risks of collecting the Canadian corporation’s accounts receivable. The agreed-upon discount rate was 2.2% but the Minister of National Revenue (the “Minister”) says it would have been just over 1% had the parties been dealing at arm’s length. The trial is expected to take approximately 6-7 weeks. The hearing began on Monday, October 17, 2011 with an opening statement by counsel for the Appellant, McKesson Canada Corporation (“McKesson Canada”).

McKesson Canada contracted to sell its accounts receivable to a related, non-resident company, McKesson International Holdings III S.à R.L. (“McKesson International”). McKesson Canada and McKesson International agreed to a variable discount rate that would be applied to the accounts receivable. The rate was calculated using a formula that resulted in a discount rate of 2.2% for the 2003 taxation year. According to the terms of the agreement, all bad debt risk relating to the accounts receivable that were sold was assumed by McKesson International. The discount rate was intended to compensate McKesson International for assuming the risk that some of the accounts receivable may not be collected and would have to be written off.

The Minister disallowed a portion of the amounts deducted by McKesson Canada in respect of the discount on the sale of accounts receivable. The Minister determined that, based on the terms and conditions in the agreement, the discount rate that would have been agreed upon had the parties dealt with one another at arm’s length would not have exceeded 1.0127%. Accordingly, the Minister added some $26 million to the Appellant’s income for its 2003 taxation year, reflecting a discount rate of 1.0127% rather than the rate of 2.2% as agreed by the parties.

In his opening statement, counsel for McKesson Canada contended that the issue should be whether the discount rate agreed upon by the parties was appropriate for an arm’s length transaction given the amount of risk that was being transferred from the vendor to the purchaser of the accounts receivable and that the issue should not be what the discount rate should be if the principal terms of the contract were changed to reflect some other hypothetical agreement used by the Minister for purposes of his assessment.

In addition to the Part I appeal, there is a Part XIII appeal as well. The issue there is whether McKesson Canada conferred a benefit on its controlling shareholder, McKesson International, under subsection 15(1) of the Act by selling certain of it accounts receivable and, therefore, whether McKesson Canada should be deemed to have paid a dividend to McKesson International under paragraph 214(3)(a) of the Act. Including interest, the Part XIII assessment is approximately $1.9 million.

In conclusion, counsel for McKesson Canada argued that the Part XIII assessment is barred by virtue of the Canada-Luxembourg Income Tax Convention (1999) (the “Treaty”), which is applicable since McKesson International is a company existing under the laws of Luxembourg. As Article 9(3) of the Treaty includes a five year time limit for changes by Canada to the income of a taxpayer, the time for the adjustment expired on March 29, 2008 (before the Part XIII assessment was mailed).

As noted in our earlier blog post, the Crown was granted leave to appeal the Federal Court of Appeal’s decision and GSK was granted leave to cross-appeal. The Crown contends in its factum that the FCA gave short shrift to the arm’s length principle which it was required to apply under subsection 69(2) of the Income Tax Act as developed in the OECD Guidelines. The Crown argues that the FCA has replaced the arm’s length standard with a “reasonable business person” test.

In its factum, GSK argues that the approach taken by the FCA in determining “reasonable in the circumstances” is consistent with the OECD Guidelines which call for the application of the arm’s length principle in light of the actual business circumstances faced by the taxpayer. Neither subsection 69(2) of the Income Tax Act nor the arm’s length principle require courts to ignore the circumstances of the marketplace. GSK also says that the Crown’s approach effectively reads out the phrase “in the circumstances” as used in subsection 69(2) of the Income Tax Act.

Finally, by way of cross-appeal, GSK takes issue with the FCA’s order that the matter be re-heard by the Tax Court of Canada, contending that that the FCA ought simply to have set the assessments aside.

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